Why do portfolios
start with indexing?

Index for alpha
In reality, there is no ‘right’ choice, at least not in the long term. Based on an extensive study of 4,500 alpha managers across 21 asset classes between 1997 and 20172, BlackRock Investment Institute (BII) looked at performance persistency of alpha managers within the top quartile over 5 year periods. A meaningful persistency probability would be above 25%. Interestingly, this is only the case for a few asset classes based on the set of confidence bands. The probability highlighted that the selection of a ‘good’ manager could not be set apart from a random probability.

Research from SPIVA3 showed that few firms remain at the top over the long run. Over 5 years, only 27% US equity managers within the top quartile in 2013 remained in the top quartile in 2018. For high yield funds the figure was 28%.

In other words, to build portfolios with consistently top performing managers involves high turnover. This constant search, selection, performance assessment and reselection is a considerable governance cost that should be taken into consideration.

Investors who do not have the capacity to research and regularly monitor their alpha seeking managers may be better to consolidate the number of alpha seeking managers in their portfolio and consider greater index selection. These choices will help to make portfolio monitoring more efficient and minimise implementation, transaction and increasing governance costs.

1 Source: Morningstar, as at March 2019. The number includes share classes.
2 Source: BlackRock Investment Institute, “Blending alpha-seeking, actor and indexing strategies: a new framework”, July 2018
3 Source: S&P Persistence Scorecard, S&P Dow Jones Indices LLC, CRSP as at September 2018. High yield surveyed 144 different managers; whilst US equity managers surveyed 1988 managers.

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“I think costs are a huge issue – clients talk about Value for Money now, that’s something that we didn’t use to have conversations around, but it’s just because costs are under the microscope across every part of the value chain. So clients squeeze us, we squeeze managers.”
- UK Wealth Manager

There is no surprise that indexing is chosen to help lower costs. The average underlying management fees are:

Beyond this, it is also important to consider the cost efficiencies of indexing. By this we refer to the concept of strategic market and style factor tilts that account for a large portion, often more than 90%, of returns generated by traditional long only equity managers. Unless a manager can capture idiosyncratic returns in excess of their management fee, it can often be more cost efficient to implement through indexing.

This is also relevant in large fund-of-fund portfolios where there are multiple active funds - often several within the same asset class. The diversification across many managers have unintendedly cancelled out positions and the potential for idiosyncratic returns, resulting in ultimately a more expensive version of the benchmark.

Index for returns
In the end, what matters most is the returns net of fees. The latest SPIVA8 report states that, net of fees, many alpha managers can underperform if they do not express strong conviction in tilts or exposures different to the benchmark.

Indexing can be an efficient way to express strategic views and control how you tilt between asset classes and factors, whilst freeing up fee budget to invest in high octane alpha and alternatives where true alpha is more likely to be rewarded.

Overall, we see that a portfolio with greater indexing coupled with true alpha-seeking and alternative managers’ results in better returns for investors.

6 Source: BlackRock Portfolio Analysis and Solutions (BPAS) Insights. Based on portfolios received from Jan 2018 – December 2018.
7 Source: BlackRock Global Business Intelligence Report, as at April 2019. Based on ETFs listed in Europe only.
8 Source: S&P Persistence Scorecard, S&P Dow Jones Indices LLC, CRSP as at September 2018.

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